A price cap is a price ________.A price cap might be a more effective way of regulating monopoly than rate of return regulation because under rate of return regulation,________.
A)ceiling;a firm incurs an economic loss
B)floor;price is set equal to marginal cost
C)ceiling;the firm's managers have an incentive to inflate costs
D)floor;the firm's managers have an incentive to purchase more than the efficient quantity of capital
E)floor;the firm's managers have an incentive to inflate costs

Question

Quizplus · Accepted Answer

A price cap is a price ceiling that limits the maximum price that a monopolist can charge. Under rate of return regulation, the regulator sets the price equal to the firm's allowable costs plus a reasonable rate of return. This creates an incentive for the firm's managers to inflate costs in order to increase the rate of return. Therefore, a price cap might be a more effective way of regulating monopoly than rate of return regulation because it reduces this incentive for cost inflation. Choice A is incorrect because a price cap is a ceiling, not a floor. Choice B is incorrect because price is not necessarily set equal to marginal cost under any type of regulation. Choice D is incorrect because the incentive for overinvestment in capital is a problem with rate of return regulation, not price cap regulation. Choice E is incorrect because the incentive for cost inflation is a problem with rate of return regulation, not price cap regulation.

A Price Cap Is a Price ________